13 IS Curve Shift in the IS curveA change in the intercept causes the IS curve to shift.Intercept = 1 * (C0 + I0 + G0 - c T0 + c TR)bAn increase in government spending or decrease in taxes increases the value of the intercept and causes the IS curve to shift up (or to the right).The size of the shift depends on the sensitivity of investment to the interest rate, b.Intermediate Macroeconomics

14 IS Curve Fiscal policy effectiveness and IS curve shiftSmall shift in IS Curve.b is large.Investment is very sensitive to changes in the interest rateLarge shift in IS Curve.b is small.Investment is not sensitive to changes in the interest rateLM CurveLM CurveIS CurveIS CurveIntermediate Macroeconomics

15 IS Curve Fiscal policy effectiveness and IS curve shiftSmall shift in IS curveClassical view, fiscal policy ineffectiveIncrease in government spending raises interest rate, which crowds out (reduces) investment spending. Net increase in aggregate spending may be smallLarge shift in IS curveKeynesian view, fiscal policy effective.Increase in government spending may raise the interest rate but has no effect on investment. Get big bang for buck.Intermediate Macroeconomics

16 IS Curve Slope of the curveEffectiveness of fiscal policy also depends on the slope of the IS curveSlope = c (1 - t)bKeynesian: small b, steep curvefiscal policy more effectiveClassical: large b, flat curvefiscal policy less effectiveIntermediate Macroeconomics

17 IS Curve Fiscal policy effectiveness and IS curve slopeFlat IS Curve.b is large.Investment is very sensitive to changes in the interest rateSteep IS Curve.b is small.Investment is not sensitive to changes in the interest rateLM CurveLM CurveIS CurveLarger increase inNational IncomeSmall increase inNational IncomeIS CurveIntermediate Macroeconomics

18 IS Curve Fiscal policy effectiveness and IS curve slopeFlat IS curveClassical view, fiscal policy ineffectiveIncrease in government spending raises interest rate, which crowds out (reduces) investment spending. Net increase in aggregate spending may be smallSteep IS curveKeynesian view, fiscal policy effective.Increase in government spending may raise the interest rate but has little effect on investment. Get big bang for buck.Intermediate Macroeconomics

19 LM Curve Money Supply and Money Demandassumed to be a some fixed levelMoney Demand:negative function of interest rate. People hold more money when interest rates decline.positive function of income. People hold more money as their income increases.Intermediate Macroeconomics

23 LM Curve Shift in the LM curveA change in the intercept causes the LM curve to shift.Intercept = - 1 MhAn increase in money supply, M, reduces the value of the intercept (more negative) and causes the LM curve to shift down (or to the right).The size of the shift depends on the sensitivity of money demand to the interest rate, h.Intermediate Macroeconomics

25 LM Curve Monetary policy and LM curve shiftSmall shift in LM curveKeynesian view, monetary policy ineffectiveIncrease in money supply is met by an increase in money demand without a significant decline in the interest rate. No stimulus to investment spending.Large shift in LM curveClassical view, monetary policy effective.Increase in money supply leads to a large decline in the interest rate in order to increase money demand. Increases investment spending.Intermediate Macroeconomics

26 LM Curve Slope of the LM curveEffectiveness of monetary policy also depends on the slope of the LM curveSlope = khKeynesian: large h, flat curvemonetary policy less effectiveClassical: small h, steep curvemonetary policy more effectiveNote: little debate over change in money demand with change in income, k.Intermediate Macroeconomics